The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law by President Obama on July 21, 2010.
Prior to enactment of this legislation, much rumbling surfaced within the private equity community over the ultimate extent and potential impact of the proposed regulations on angel and venture capital investment. The concern was that anything that made raising capital more difficult for early-stage companies was bad – for businesses, for investors, for job creation, and hence, for the economy.
Background on the Sale of Securities
Most emerging companies seek to raise capital by selling securities. The securities must be either registered with the Securities and Exchange Commission and applicable state securities law commissions, or sold pursuant to an exemption from registration. Startup companies frequently rely on an exemption from registration, since registration can be a lengthy and prohibitively expensive process. The most frequently used exemptions are found in Regulation D under the Securities Act of 1933. Of the exemptions under Regulation D, Rule 506 is the most commonly used by startup companies, because of the relatively modest disclosure requirements and compliance costs.
Under Rule 506, a company can sell its securities to an unlimited number of accredited investors and up to 35 non-accredited investors without registration (definitions of “accredited” and “non-accredited” described below). Although a company is not required to make any specific disclosures to accredited investors, if a sale is made to a non-accredited investor, the company must disclose to the non-accredited investor certain information that is generally the same as is required in registered offerings, such as information about the company, the company’s business, the offering, and the risks involved. Because of the increased and substantial costs of providing such information (think of additional attorney and accountant fees), I advise startup clients to avoid non-accredited investors.
Unaccredited Investor: Additional time + Very expensive + Other risks + IncessantlyDemanding = AVOID!
Non-compliance with the securities laws can result in significant monetary and injunctive penalties against a company, including the right of investors to receive their money back plus interest.
Generally, dealing only with accredited investors is much less costly and easier for the company and for investors.
So, what is an “accredited” investor?
The SEC uses the accredited investor test as a means to determine whether an investor has the ability to bear the economic risk of a private placement investment.
An “accredited” investor, as defined in Regulation D, is one of the following:
- a bank, insurance company, registered investment company, business development company, or small business investment company;
- an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
- a charitable organization, corporation, or partnership with assets exceeding $5 million;
- a director, executive officer, or general partner of the company selling the securities;
- a business in which all the equity owners are accredited investors;
- a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;
- a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
- a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.
An investor that does not meet any of the above criteria is non-accredited.
Why should a startup be concerned about the Dodd-Frank Act?
Under the Dodd-Frank Act,
- The standard for determining the net worth of a natural person now excludes the value of the person’s primary residence.
- The SEC may review the definition of “accredited investor” as such term applies to natural persons to determine whether any modifications are appropriate for the protection of investors, in the public interest, and in light of the economy.
- Beginning in July 2014, the SEC is directed to review the definition of “accredited investor” at least once every four years to determine whether changes are needed for the protection of investors, in the public interest, and in light of the economy.
By most accounts, the Dodd-Frank Act is not as onerous as feared, because many of the proposed provisions relating to the private placement of securities were omitted in the final legislation. Venture capital was spared, since certain regulations in the bill that would have required VC firms with over a certain amount of assets to register with the SEC were excluded from the final Act. The Act did, however, address the definition of “accredited investor,” which had not been revised since 1982, to account for increases in salaries and home values since the early 1980’s, and to provide a mechanism through which the SEC can revise the definition as appropriate going forward.
For emerging companies, changes to the definition of accredited investor could potentially reduce the number of individuals who qualify as accredited investors, which could have a negative effect on angel and venture capital investment by raising the cost of obtaining financing.
Most pressing for a company in the middle of a funding transaction or seeking financing: review subscription and disclosure documents immediately to ensure compliance with this new standard, or risk running afoul with federal and/or state securities laws.
Next up for venture capital: The Carried Interest debate.
